Dynamic Sources of Sovereign Bond Market Liquidity

Abstract

Using 482 US Dollar and Euro denominated bonds issued by 72 sovereigns, we examine the dynamic sources of time-series and cross-sectional variations in \textit{market-wide liquidity} of sovereign bonds as a novelty in the sovereign fixed income literature. Vector autoregression analysis shows that macroeconomic fundamentals and the financial market variables play a substantial role in the movements of aggregate liquidity throughout the whole sample period (1999-2010), although their effects are stronger during the financial crisis. Specifically, US industrial production growth rate and inflation rate have significant informative powers on the sovereign bond market liquidity. An increasing shock to the TED spread (the spread between 3-Month Libor and US T-bill), a measure of distrust in the banking system, has detrimental impact, while equity market performance is positively linked to market-wide bond liquidity. Furthermore, the direction of causality from the world financial and macroeconomic variables towards the aggregate bond market liquidity is confirmed by Granger causality tests. Finally, impulse response functions show that these relationships are persistent up to one-year forecast horizon.